It's the Economy, Not the Uncertainty, Stupid

By Matthew O'Brien

There's one certainty about the economy. Uncertainty is bad for it.

Actually, there's another certainty about the economy. Uncertainty never goes away. Sometimes we forget this; then we belatedly remember it. This alternating cycle of optimism and pessimism is what Keynes famously called "animal spirits" -- in other words, the psychological drama that drives our economic drama.

And it does drive the economy. Consider the chart below, which compares the inverted share of gross private investment in the economy with the unemployment rate. When investment goes up, unemployment goes down -- and when investment goes down, unemployment goes up. The correlation is particularly tight the past 20 years.

Why does investment drive the business cycle? Because sentiment can change so suddenly, and investment depends on sentiment. Of course, this is just another name for uncertainty -- or at least our awareness of it. When we finally do realize how hard predictions are -- especially about the future! -- everything changes. We worry more about the return of, rather than the return on, our money.Greg Ip of The Economist points out that an old Princeton professor named Ben Bernanke was very much mindful of the way investors hold off on making long-term commitments when the long-term looks hazy.

But not all uncertainty is created equal. There's uncertainty over how what the economy will do in the future, and there's uncertainty over what policymakers will do in the future. These are not, of course, mutually exclusive. It's this policy uncertainty that Mitt Romney's economic team says is to blame for our subpar recovery. In other words, questions about what will happen to the Bush tax cuts, financial reform rule-making, and the costs of healthcare reform are holding back business investment -- or so the story goes. All it needs is some evidence.

What would this evidence look like? Well, if policy uncertainty really is the culprit for low investment, we would expect our investment growth to lag that of other rich countries since the financial crisis ended. The below chart looks at how much investment as a share of GDP has grown from 2009 to 2011 for developed nations that were all hit fairly hard by the recession.

This is what meh looks like. But there's a lot of meh to go around. Even if you look at the change from 2007 to 2011 -- which is a far less flattering picture for us -- we're still doing just about as well or better than the United Kingdom, New Zealand, Denmark, the Czech Republic and the Slovak Republic. And none of them face a fiscal cliff next year. Or recently revamped their healthcare systems. Or passed new financial regulations.

In other words, our slow investment is mostly a story about uncertainty over the economy, not uncertainty over policy. Just like everywhere else.

That hasn't stopped the Romney camp from insisting otherwise. Exhibit A in their case is a paper by Steven Davis of the University of Chicago and Nicholas Bloom and Scott Davis of Stanford that claims uncertainty hurt GDP by 1.4 percentage points in 2011. That sounds bad, but if you actually read the paper you'll see that the biggest effects came from the debt ceiling showdown and the euro crisis, not tax or regulatory uncertainty. You'll also see that the paper's methodology is seriously flawed -- it registers political talking points about uncertainty as evidence of uncertainty -- as Mike Konczal of the Roosevelt Institute pointed out.

Okay, there might be one last certainty about the economy. Uncertainty is principally a question about how bad the economy will be. This can feed on itself in a self-fulfilling cycle of doubt -- and that makes policy both more important and more uncertain. In other words, economic uncertainty often spawns policy uncertainty. But the fundamental issue, as Dylan Matthews of the Washington Post explains, is still the bad economy.